Question 4 OR (a)
EBIT indifference level: equity versus debentures
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 4 OR (a) · 8 marksGrant Ltd.'s data is as below:
Existing Capital Structure: Equity Shares, 10 lakh of ₹10 each; the Tax Rate is 50%.
To finance an expansion project, Grant Ltd plans to raise additional capital of ₹100 lakhs. It is evaluating two alternative plans:
An issue of 10,00,000 equity shares of ₹10 each;
An issue of ₹100 lakh debentures carrying a 14% rate of interest. You are required to calculate the EBIT indifference level.
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
No interest-bearing debt exists in the present structure; the existing 10 lakh shares stay under both plans.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Shares and interest under each plan 2 marks 3 min
- 2 Indifference equation and EBIT 4 marks 7 min
- 3 Check and interpretation 2 marks 3 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Short on time? Step 2 carries 4 of the 8 marks: guard its minutes.
Try it first. About 16 minutes for 8 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Indifference point. The EBIT at which two financing plans give the same EPS; it is found by equating their EPS.
| Particulars | Plan (i): equity | Plan (ii): debentures |
|---|---|---|
| Existing shares | 10,00,000 | 10,00,000 |
| New shares | 10,00,000 | — |
| Total shares (N) | 20,00,000 | 10,00,000 |
| Interest (I) | — | 14,00,000 (14% × ₹100 lakh) |
Let X be the indifference EBIT; tax 50%:
X × (1 − 0.5) ÷ 20,00,000 = (X − 14,00,000) × (1 − 0.5) ÷ 10,00,000
X = 2(X − 14,00,000), so X = ₹28,00,000.
Check. At EBIT ₹28,00,000: plan (i) EPS = 28,00,000 × 0.5 ÷ 20,00,000 = ₹0.70; plan (ii) EPS = (28,00,000 − 14,00,000) × 0.5 ÷ 10,00,000 = ₹0.70.
Interpretation. Above ₹28 lakh of EBIT the debenture plan gives the higher EPS; below it, the equity plan does.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Shares and interest under each plan | 2 |
| 2 | Indifference equation and EBIT | 4 |
| 3 | Check and interpretation | 2 |
| Total | 8 |
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